In case you missed it, there was an epic smackdown last week between Warren Buffett and Bill Gross of PIMCO fame. It wasn’t actually a smackdown, but on the same day it was revealed that Bill Gross had ramped up the holdings of U.S. treasuries in his mega-bond fund to 38% of assets, Warren Buffett said that treasuries was the most “dangerous” asset class in investments. Warren has a point. At this level of rates, the price risk in longer-term treasuries is huge. Investors can buy high-quality dividend stocks at yields well above bond rates and can participate stock rallies. I am certainly not one to argue with Buffett, nor am I a huge fan of Bill Gross. But Buffet is forgetting one thing.
After the double knock-out blows of stock market and home equity meltdowns, for many investors it’s all about return of principal, not return on principal. You’ve probably heard that before. Many individuals, especially those in or near retirement, simply cannot afford to risk money on stocks. At least with bonds, you know you will get your money back on a fixed date. That’s simply not true for stocks. It’s entirely conceivable, given the European risk, that stocks could fall by 40-50% from this point. And, there is no guarantee that stocks would bounce back this time. Consider Japan. Over twenty-two years ago the double collapse of stocks and home equities struck, and today the Japanese stock market index remains at roughly 25% of its peak and the 10-year note rate in Japan has been stuck near 1% for over a decade. Bond investors are actually earning more on a deflation adjusted basis. Investors at first resisted switching to all Japanese bonds for the first ten years, but surrendered to staying in bonds after countless false starts.
It’s not just individuals who opted for return of not on principal. Global institutions and central banks also gorged on our mortgage backed bonds. Today those entities still want the safety of U.S. assets but not the risk. Those huge funds have flowed into treasuries at the sacrifice of returns. Pension funds could be next, but there will have to a revolution in re-writing pension benefits first.
We are likely in a different world in which a once in a lifetime secular event has taken place. In the Buffett/Gross smackdown it’s awfully tempting to bet on Buffett, but this could be a Gross world.